The Gold standard

The gold standard is a monetary system in which the standard unit of currency is a fixed weight of gold or is kept at the value of a fixed rate of gold with paper money convertible on demand into gold. Under such a system money represents gold: coins are made of the corresponding amount of gold, and/or coins and notes represent an amount of gold held in a vault somewhere. Rates of exchange between countries were fixed by their currency values in gold.

Most financially important countries were on the gold standard
from 1900 until it was suspended in many nations during World
War I (notably in the United
States it was not suspended during the war). It was reintroduced
partially in 1925 as the Gold Exchange Standard but finally abandoned
in 1931. In Great
Britain it was Winston
Churchill in his role as
Chancellor of the Exchequer that was responsible for initiating
the 1925 return.

In an internal gold-standard system, which implies the use of an international gold standard, gold coins circulate as legal tender or paper money is freely convertible into gold at a fixed price.

In an international gold-standard system, which may exist in the absence of any internal gold standard, gold or a currency that is convertible into gold at a fixed price is used as a means of making international payments. Under such a system, exchange rates rise above or fall below the fixed mint rate by more than the cost of shipping gold from one country to another, large inflows or outflows occur until the rates return to the official level.

If all circulating money can be represented by the appropriate amount of gold, then this is known as a 100% reserve gold standard, or a full gold standard. Some believe there is no other form of gold standard, since on any "partial" gold standard the value of circulating representative paper in a free economy will always reflect the faith that the market has in that note being redeemable for gold. Others, such as some modern advocates of supply-side economics contest that so long as gold is the accepted unit of account then it is a true gold standard.

The commitment to maintain gold convertibility tightly restrains credit creation, because doing so would be to commit fraud. Credit creation by banking entities under a gold standard threatens the convertibility of the notes they have issued, and consequently leads to undesirable gold outflows from that bank. This is caused when people realise that the bank notes are, in a sense "oversold", and go to redeem their notes for their printed face value in gold - if they are quick enough.

Hence, notes circulating in any "partial" gold standard will either be redeemed for their face value of gold (which would be higher than it's actual value) - this constitutes a bank "run"; or the market value of such notes will be viewed as less than a gold coin representing the same amount.

In classical economics imbalances in international trade were rectified automatically by the gold standard. A country in deficit would have to pay its debts in gold thus depleting gold reserves and would therefore have to reduce its money supply. The resulting fall in demand would reduce imports and the lowering of prices would boost exports; thus theoretically the deficit would be rectified.

In practice however this could seriously destabilise the economy of countries which ran a trade deficit, because people tended to make a run on the bank to retrieve their money before gold reserves were exported, thus causing banks to collapse and wiping out savings. Bank runs and failiures were a common feature of life during the period when the gold standard was the established economic system.

The gold standard limits the power of governments to cause price inflation by excessive issue of paper currency, although there is evidence that before World War I monetary authorities did not expand or contract the supply of money when the country incurred a gold outflow. Theoretically it also creates certainty in international trade by providing a fixed pattern of exchange rates.

Thus, the gold standard is supported by many advocates of classical economics, monetarism, Objectivism, and even proponents of libertarianism.

However, the disadvantages are that it may not provide sufficient flexibility in the supply of money, because the supply of newly mined gold is not closely related to the growing needs of the world economy for a commensurate supply of money. A single country may also not be able to isolate its economy from depression or inflation in the rest of the world. In addition, the process of adjustment for a country with a payments deficit can be long and painful whenever an increase in unemployment or decline in the rate of economic expansion occurs.

Opponents of the gold standard such as Keynesianists argue that the gold standard creates deflation which intensifies recessions as people are unwilling to spend money as prices fall, thus creating a downward spiral of economic activity.
The gold standard also removes the abillity of governments to fight recessions by increasing the money supply to boost economic growth.

Opponents of the gold standard thus argue that an expanding economy with a supply of gold that increases more slowly than the economy expands would cause a tiny, but steady, deflation. It is believed by gold standard opponents that this gradual deflation would throw the economy into recession.

No mainstream economist today advocates a return to the gold standard.

However, a near century-long period of deflation
has already occurred in Britain while on the Gold Standard during
the 1800s. During that century the price, in gold, of goods and
services in Britain was halved. The gradual century of deflation
did not cause a century of recession. Quite the contrary, the British
empire during that period was the undisputed economic power of the
world.

However critics of the gold standard say that this may well have been due to the fact that Britain was able to import cheap raw materials from the Empire and manufacture goods more cheaply than its competitors, allowing it to run trade surplusses.

The Sumerians, as part of their development of a standard of weights and measures, placed the royal stamp on each piece of gold to guarantee that it was the same amount as every other similarly stamped gold piece. They simply agreed that this was worth a bushel of wheat - the value was never in the gold. For each amount of gold issued by the king, a certain amount of wheat is kept in reserve in order to ensure that gold has some value. This ensures that the value of the gold with respect to wheat did not change - no inflation with respect to wheat. When the gold is returned to the king, it is redeemed with the wheat that it represented. This, in effect, is a "wheat standard".

The problem with the idea of a gold standard is that it is similar to the creation of a "dollar standard" - creating a new currency to use, while holding a reserve of dollars in the bank to give the new currency some legitimacy. The problem is that the commodity held in reserve was merely a unit of exchange and derives its value mainly from its previous use as currency. The original backing of the currency is lost.

The gold standard was first put into operation in Great
Britain in 1821. In the full internal and international gold
standard of the pre-1914 world, gold could be exchanged for equal
weights of gold coinage, coins could be melted down for their gold
content, and gold coin or bullion could be exported freely.

Traditionally, the gold standard was not limited to one or two countries; it was an international system. With gold as money, international trade was conducted much more smoothly than it is now. With a gold standard, or indeed, with any money based on specie, traders and travellers need not constantly be concerned with losses they may suffer from exchange rate fluctuations. This also means that in a worldwide gold or specie standard, poor countries are not at the whim of international currency speculation. Those living in poor countries can instead depend, from year to year, on the value of their exports, the cost of their imports, and interest on their debts. With a specie or gold standard, poor countries are not at the whim of the currency manipulation of governments of more wealthy nations.

The reign of the full gold standard was short, lasting only from
the 1870s to the outbreak of World War I. In the post-World
War I period, banknotes were issued fractionally backed by gold
(i.e. gold reserves were a fixed proportion of the value of the
notes in circulation). By 1928, however, both the internal and international
gold standards had been virtually re-established, although gold
coins were no longer in general circulation in most countries, and
more extensive use was made of the gold exchange standard than before
1914. The gold standard collapsed again during the Great Depression
of the 1930s. By 1937 not a single country remained on the gold
standard.

The post-World
War II system agreed on at Bretton
Woods was one in which most exchange rates were pegged either
to the dollar or to gold. In 1958 a type of gold standard was re-established
in which the major European countries provided for the free convertibility
of their currencies into gold and dollars for international payments.
There was no restoration of an internal gold standard.

The United
States dollar started on a bimetallic
standard, which was effectively a silver standard, and switched
to a gold standard in 1901 (see Gold
Standard Act). Starting in 1933, U.S. currency was no longer
directly convertible by individuals to gold and the possession of
gold by individuals for investment purposes was made illegal. Transfers
of gold were still used to settle liabilities between central
banks.

Starting in the 1950s, the United States began running persistent
trade imbalances which created liabilities in the United States
to other central banks, and beginning in the early 1960s, the United
States no longer had sufficient gold to cover liabilities to other
nations. To help alleviate this problem, the United
States Congress on March 18, 1968 repealed the requirement for
a gold reserve to back US currency. However US dollars could still
be converted to gold. This became a serious problem in the early
1970s when a lack of confidence in the U.S. dollar
led to mass redemptions of US dollars for gold. As a result, the
United States went off the gold standard on August 15, 1971 when
President Richard
Nixon announced that the United States would no longer convert
dollars to gold at a fixed value.

Nixon's move to cease allowing foreign Governments to redeem dollars
for precious metal was the final act in a 150-year-long 'transfer'
of the citizen's gold and silver to the Federal Government's vault.
This allowed the U.S. Government to have much more freedom in determining
the rate of printing and volume in circulation of its fiat
currency.

Nixon's move also denatured the Bretton
Woods system and left the International
Monetary Fund, Bank
For International Settlements and World
Bank all without any foundation for global monetary
policy other than to rely on the US dollar as a reserve currency.
This was seen as an imperial
move by many, removing any and all semblance that these institutions
were mediators or regulators of money
markets. They were, in effect, marketing agencies for the US
dollar and a system in which other currency was necessarily enslaved
to it.

In the words of John
Kenneth Galbraith, in his 1975
book : Money: whence it came, where it went: "There is
a notable asymmetry in the relation of the United States to the
rest of the trading world. The United States is sufficiently self-contained
in its economic relations with other countries so it can go far,
given the will and wisdom, to stabilize its own prices. But if prices
in the United States are rising, there are few other countries that
can avoid the resulting impact. They can have more inflation than
the United States; They cannot have less."

Alan
Greenspan at around the same time spoke of the power of the
gold standard to restrain the inflation caused by governments.

Because the British Pound
Sterling was based on the gold standard, throughout the 19th
century there was a steady small deflation, which is a gradual increase
in the buying power of gold. During the 19th century the rate of
growth of the British economy was around 5% p.a., but the gold supply
only expanded by around 3-4% p.a. during that time. This meant that
as time went on the same weight of gold had more purchasing power.
As a result of this effect, by the end of the 19th century the gold
price of goods in Britain was around half what they cost at the
beginning of the century. Britain, far from suffering a continuous
recession, was unarguably the worlds strongest economy during the
19th century while on the gold standard.

Today gold is often kept as a hedge against the US dollar or other G8 "hard currencies".

In addition to other precious metals, it has three major competitors
as a store
of value: the US dollar itself, the Chinese yuan
which is not (as of 2003) traded on markets and has similar self-sufficiency
advantages as the USA did in '75, and real
estate (which of course is dependent on property
rights recognized in a country). None of these has the stability
of gold had, thus there are occasionally calls to restore the gold
standard, or to move to a new standard based on ecological yield
of natural
capital, e.g. Global
Resource Banking. Given the difficulty of assessing such standards
as compared to the simple weighing of gold, it seems not likely
they can really take hold.

Some privately issued modern currencies (such as e-gold) are backed by gold bullion.

Tantalum is also suggested as an alternative money supply standard, since even in an economy based on molecular engineering it would remain extremely difficult to forge - and remain quite easy to hide.